An overheated market intoxicated by cheap credit serves as a warning to investors

by: John Gapper

There are few surer financial warnings than Stephen Schwarzman, co-founder of the private equity group Blackstone, throwing a big party. His 60th celebration a decade ago marked the pre-crisis peak for the industry, so the 70th birthday party he held last month in Palm Beach, Florida, featuring fireworks, camels, and a cake in the shape of a Chinese temple, is worrying.Private equity entered a slump after his 2007 party, with the huge debt-financed deals struck at the peak looking stupid with hindsight. Ten years later, it is doing extremely well for itself. As hedge funds stumble and public stock markets are increasingly dominated by passive index funds, veterans such as Mr Schwarzman and Leon Black of Apollo are masters of their universe.It is a safe bet that this will not last, since it never has before. The global industry gathers every year at a conference called SuperReturn, held in Berlin this week. The name is not always merited but this year’s resembles a crowded party that could erupt at any moment. Cocky financiers in expensive suits, intoxicated by cheap credit and high dividends? Run for the exits.Even this was bearable until Mr Black took to the SuperReturn stage on Monday to declare that, although a correction was probably imminent, it could be postponed by Donald Trump’s pledge of a “revved up” US economy. That could unleash a further three years of “turbocharged” growth for leveraged buyouts backed by the $820bn of capital yet to be invested. Then I really got nervous.Private equity’s problem is not that it is suffering but the opposite: it has recovered so fully that it is flush with money. As it sells the businesses it bought a few years ago, many at a high profit, and returns cash to the pension funds and institutions that invest through it, more is arriving. This is a very good period to be selling assets but a hard one to find a bargain.The industry should still have advantages even in these heady times. Compared with hedge funds, which also charge stiff fees to invest other people’s money, it has performed well. Warren Buffett wrote harshly of hedge fund managers in his annual letter to Berkshire Hathaway investors, but has partnered with 3G, the Brazilian-led private equity firm. The classic private equity deal is to borrow money to buy a medium-sized company that is in decent shape but has potential to grow or become more efficient. A fund often puts in new managers, allocating them a hefty incentive to improve the business — private equity chief executives get an average 8 per cent stake, according to one study. It then sells at a higher price five years later. Having the luxury of privacy and time — not having to worry about quarterly results or investors demanding their money back — helps investments thrive. The industry consistently outperformed the stock market up to 2006, one study found, and its long-term performance has recovered from a post-2008 dip. But no matter how much leverage and ambition it injects into a company, a private equity fund cannot easily compensate for overpaying. This is the pressing problem: one investor estimates that his fund must pay 15 or 20 per cent more to buy a company with stable earnings than it did two years ago. Funds prefer to find companies and take time — sometimes years — to size them up and get to know their founders or executives. The new reality is often that, as one partner describes it: “You get a book sent by Goldman Sachs, one dinner with a camera-ready executive team, and then an auction.” They are not only competing against each other. The most enthusiastic bidders are often companies in the same industry that can obtain cost savings by integrating a smaller rival. Pension funds are also getting in on the act by co-investing with private equity funds, and sometimes investing directly. The obvious response to an overheated market is to slow down, and even to take a break from investing until prices fall. In theory, this should be an advantage of private equity funds — they do not have to place funds immediately, and will not benefit their investors by rushing. Most are pressing ahead anyway. They believe they have a unique formula that will keep their investments safe while others overpay. They do not say, although it is true, that they only get rewarded for action. They charge a 1.5 per cent management fee on their investments.If you pay a lot, you need to get value somehow. The danger is that they start treating every company like a distressed asset to obtain a return, even if it was originally fine. They may be pushed into acting more like 3G, which one investor calls a “brutal” cost-cutter at companies including Kraft Heinz, where it eliminated 13,000 jobs.The private equity industry should enjoy the party while it lasts. The fun could soon be over.

NEW HAVEN – Corporate tax cuts are coming in the United States. While this push pre-dates last November’s presidential election, President Donald Trump’s Make-America-Great-Again mantra has sealed the deal. Beleaguered US businesses, goes the argument, are being squeezed by confiscatory taxes and onerous regulations – strangling corporate earnings and putting unrelenting pressure on capital spending, job creation, and productivity, while sapping America’s competitive vitality. Apparently, the time has come to give businesses a break.

But this argument raises an obvious question: If the problem is so simple, why hasn’t this fix already been tried? The answer is surprising.

For starters, it is a real stretch to bemoan the state of corporate earnings in the US. Commerce Department statistics show that after-tax corporate profits (technically, after-tax profits from current production, adjusted for inventory and depreciation-accounting distortions) stood at a solid 9.7% of national income in the third quarter of 2016.

While that is down from the 11% peak hit in 2012 – owing to tepid economic growth, which typically puts pressure on profit margins – it hardly attests to a chronic earnings problem. Far from anemic, the current GDP share of after-tax profits is well above the post-1980 average of 7.6%.

Trends in corporate taxes, which stood at just 3.5% of national income in the third quarter of 2016, support a similar verdict. Yes, the figure is higher than the post-2000 level of 3% (which represents the lowest 15-year average tax burden for corporate America since the 2.9% reading in the mid-1990s); but it is well below the 5.2% average share recorded during the boom years of the post-World War II era, from 1950 to 1969. In other words, while there may be reason to criticize the structure and complexities of the US corporate tax burden, there is little to suggest that overall corporate taxes are excessive.

Conversely, the share of national income going to labor has been declining. In the third quarter of 2016, worker compensation – wages, salaries, fringe benefits, and other so-called supplements such as social security, pension contributions, and medical benefits – stood at 62.6% of national income. While that represents a bit of a rebound from the 61.2% low recorded in the 2012-2014 period, it is two percentage points below the post-1980 average of 64.6%. In other words, the pendulum of economic returns has swung decisively away from labor toward owners of capital – not exactly a compelling argument in favor of relief for purportedly hard-pressed American businesses.

But what about the seemingly chronic weakness in capital spending and job creation, widely thought to be additional manifestations of overly burdened US companies? Yes, both business investment and employment growth have been glaring weak spots in the current recovery. There is a distinct possibility, however, that this is due less to onerous taxes and regulatory strangulation, and more to an unprecedented shortfall of aggregate demand.

Economists long ago settled the debate over what drives business capital spending: factors affecting the cost of capital (interest rates, taxes, and regulations) or those that influence future demand. The demand-driven models (operating through so-called “accelerator” effects) won hands down.

This is logical. Businesses can be expected to expand capacity and hire workers only if they anticipate that their markets will grow in the future. For the US, that may also be a stretch. Since the first quarter of 2008, inflation-adjusted personal consumption expenditures in the US have grown by just 1.6% annually, on average – fully two percentage points below the 3.6% norm in the 12 preceding years. In fact, the current period is the weakest 35 quarters of real consumption growth in post-WWII history. If past is prologue – as it is for many businesses as they frame their expectations – the focus on tax relief and deregulation could ring hollow, without addressing weak consumer demand.

It’s the same story with competitiveness. Trump repeatedly bemoans the loss of America’s once-dominant competitive position. To restore it, Trump’s “America first” campaign is framed around an explicit endorsement of protectionism, underscored by the haunting words of his inaugural address: “Protection will lead to great prosperity and strength.”

But Trump’s narrative of a once-great America that has supposedly lost its competitive edge is at odds with the best available evidence: an annual compendium published by the World Economic Forum (WEF), which provides a detailed assessment of 114 individual competitive metrics for some 138 countries.

In the WEF’s 2016-17 Global Competiveness Report, the US came in third in terms of overall international competitiveness (behind Switzerland and Singapore) – maintaining pretty much the same position it has held over the past decade. Yes, the US scores poorly on corporate tax rates, regulation, and government bureaucracy; but it more than compensates for those shortcomings with exceedingly high rankings for capacity for innovation (2/138), company spending on research and development (2/138), and availability of scientists and engineers (2/138).

Impressive scores on financial-market development, labor-market efficiency, and several aspects of business sophistication are also big pluses for America’s consistently high rankings in the WEF’s global tally. In short, the US has hardly lost its competitive edge.

In an ideal world, it would be nice to streamline, simplify, and even reduce tax and regulatory burdens on US businesses. But business is not the weak link in the US economic chain; workers are far more vulnerable. Economic returns have shifted dramatically from the providers of labor to the owners of capital over the past 25 years. That, more than anything, speaks to the need for an urgent reordering of the priorities in America’s national economic-policy debate.

The stock market reached yet another new high on Wednesday, the latest development to make a mockery of what savvy economic commentators thought they knew about the world.

Consider how things looked one year ago. The world economy seemed hopelessly trapped in a cycle of low growth and inflation. Markets recoiled at the mere possibility that the Federal Reserve would raise interest rates. Populist political insurgencies seemed to threaten yet more financial market chaos.

Now, interest rates and inflation forecasts have risen substantially from last winter’s lows; financial markets are shrugging off — or even rallying at the possibility of — imminent Fed rate increases; and it is all taking place during Donald J. Trump’s presidency.

An economy that seemed locked in some form of “secular stagnation” or “new normal” is at long last showing some signs of being in something closer to an “old normal.” The United States manufacturing sector is showing strength, and the broader mix of market and economic data from around the world in the last few months also points to a world where a vicious economic cycle isn’t looking quite as scary and may even be ending.

There can be no assurance that this pattern will continue, and there are some things to worry about on the horizon, not least that the Trump administration could follow through on some of its threats to disrupt global trade and diplomatic relations. Long-term interest rates remain low by historical standards across most of the world, suggesting that global bond investors aren’t fully buying into a return to stronger, more consistent growth.

But the pivot since Election Day is huge. The Standard & Poor’s 500 index is up 12 percent since Nov. 8, the London FTSE 100 index reached a new high Wednesday, and other global markets have grown nicely in that span. Ten-year Treasury bonds now yield 2.45 percent, up from 1.85 percent on Election Day, suggesting investors believe higher growth and inflation are more probable than had seemed likely just four months ago.

Much of the buoyant optimism on Wall Street is driven by investors’ expectations of corporate tax cuts and deregulation under the Trump administration. But there is also some real improvement in the economic data underneath the shifts, reflecting economic forces that have been underway for years. And this resetting of expectations is evident in market data beyond the always erratic stock market.

On Wednesday, that took the form of a new survey of manufacturing supply managers that showed the factory sector is expanding at a breakneck pace. As recently as August, that same index from the Institute for Supply Management was contracting. Those numbers followed positive readings on retail sales, industrial production and the job market.

For years, a theory that the major world economies were stuck in a pit of “secular stagnation” had gained hold — the idea that low economic growth, low inflation, low interest rates and weak productivity growth were all reinforcing one another in a vicious cycle.

There’s hardly enough evidence to toss that theory aside, but there are many reasons to think things are now looking up.

For example, bond market prices now suggest that investors foresee consumer price inflation in the United States at 2.03 percent a year over the coming decade — consistent with the 2 percent inflation the Fed aims for. It only recently reached that level, however, after being as low as 1.2 percent in February 2016. And it’s not just the United States. Similar measures of inflation expectations have risen in Germany, Britain and other advanced economies.

For a window into the changing mind-set of investors, consider some news around the Fed this week. Tuesday afternoon, William C. Dudley, the president of the New York Fed, said in an interview that it would be fair to assume that the central bank would raise interest rates sooner rather than later, given the improving economy.

“There’s no question that animal spirits have been unleashed a bit post the election,” Mr. Dudley told CNN.

Fed watchers interpreted that to mean that an interest-rate increase could be on the way in mid-March, just three months after the last increase in December. Yet that did nothing to slow the 1.4 percent gain in the Standard & Poor’s 500 on Wednesday, and may even have contributed to it, as a sign of the Fed’s confidence in the economy.

A year ago, hints that the Fed would move quickly with rates would have sent markets into a tailspin. As 2016 began, Fed leaders were expecting to raise rates four times in that year, plans that helped send the stock market plummeting and measures of economic pessimism soaring. Then they backed off and only raised rates once.

Since a stock market rally began on Election Day, there has been plenty of discussion about a Trump effect. And no doubt a big part of the improvement has resulted from expectations that the new president’s policies will help corporate bottom lines (and that some of the risks of his trade agenda won’t materialize).

But it’s worth keeping in mind that a so-called Trump bump arrives as the economy is closing in on its full productive capacity. It is getting to the point where a cycle of rising wages and higher inflation necessitates higher interest rates. That, in turn, reflects policies from the Obama administration and the Fed that long predate Mr. Trump’s election.

Conventional economic theory predicts that if a government tries to increase deficits at a time of full employment, the results will be some mix of higher inflation and higher interest rates, crowding out investment.

So if tax cuts, more military spending and other Trumpian policies add to deficits at a time the economy is already running at full blast, rising prices and rising rates are exactly what we would expect to see.

Geographic features and conditions are part of the building blocks of geopolitical analysis. And yet, the influence that geography has on a country’s imperatives and constraints can be underappreciated. Access to water is an important example. While the media and academics treat water primarily as an issue of climate and human rights, access to and control over water is a strategic imperative that has been the impetus of conflict throughout history.

Something as simple as water access can impact the geopolitical realities a country faces in multiple ways. The first and perhaps the most obvious way is sea access. Access to the world’s oceans enables a country to more easily participate in major maritime shipping routes. It also opens an additional route by which a country could project force by having a navy.

The imperative to attain and maintain ocean access can drive a country to extreme measures, including war. One major component in the War of the Pacific in South America (1879-1883) was control over access to the southern Pacific. Bolivia lost its ocean access as a result of this war and continues to this day to seek ways to recover it. A more current example is Russia’s invasion of Crimea to create a larger buffer around Russian naval facilities in Sevastopol.

The Mighty Mississippi

Waterways also provide cheaper means of shipping goods to port for export, making exports more competitive.

One of the most strategic riverways in the world is the Mississippi River system in the United States. Two great rivers, the Missouri and the Ohio, along with several smaller rivers flow into the Mississippi. This river system is navigable and empties into the Gulf of Mexico. That means virtually any part of the land between the Rockies and Appalachians that would produce agricultural products (and later minerals) could ship goods inexpensively through this river system and eventually to Europe.

In this case, the US acquired these lands primarily through the Louisiana Purchase, followed by a war with Mexico and the annexation of Texas. This led to the expansion of a buffer zone to the west of the Mississippi River.

The Nile

Rivers can also be sources of geopolitical power in terms of relations between states. This is the case with the Nile River. Approximately 85% of all water reaching the Nile River in Egypt originates in Ethiopia from the Blue Nile, Atbara, and Sobat rivers. Of these rivers, the most important is the Blue Nile. It accounts for nearly 60% of the Nile’s water in Egypt. Given that Egypt is overwhelmingly a desert climate, the country (especially populations near the Nile) depends heavily on the river for water and agriculture.

Controlling the source of the river’s water and the upper-most segment of the Blue Nile means that any moves Ethiopia makes that affect water flow or quality could jeopardize water access downstream. Currently, there is much concern over the Grand Ethiopian Renaissance Dam (expected to be operational this year) regarding how filling its reservoir could deplete water flowing into Egypt.

So far, this concern has been dealt with through diplomacy. However, in the mid-1870s, the Khedevite of Egypt invaded Ethiopia via Eritrea and waged war for two years in an attempt to gain control of the Nile River.

Syria

Lastly, the absence of water can indirectly lead to conflict. The map above shows areas in Syria that experienced six or more years of drought from 2000 to 2010. Prolonged droughts can decimate a region’s agriculture and livestock, exposing local food supplies to great risk.

In addition, the Islamic State took control of some of this overlapping territory only a few years after the drought. The United Nations International Strategy for Disaster Reduction published a 2011 study implying that social and economic devastation caused by drought contributed to the rise of IS. Historians have also noted a correlation between major famine due to drought in Ethiopia and the fall of regimes, such as the Derg. While drought in these cases did not serve as a direct trigger for observed violence, there is a strong correlation between the absence of water and social and economic instability.

The Importance of Access

Water serves as a mainstay component of geopolitical imperatives and should be understood as such. Access and control over waterways and bodies of water can provide strategic standing to a country. In some cases, it can even enhance this standing in terms of military projection, trade, domestic stability, and leverage over other countries. For this reason, water has an underlying geopolitical importance. Access to and control over water can be a serious source of conflict among nations… conflict that has the potential to rise to the level of warfare.

Rates have been stuck in a range for months, but there are signs they will go down, not up, in the near future.

By Michael Kahn

Interest rates on the long end of the curve haven’t really moved since November. The current sideways action seems to be a pause in a new rising trend, but recent action in both the bond market and interest-rate-sensitive stocks paints a different picture. It is now possible that long-term rates could move back down -- despite increases in short-term rates by the Federal Reserve.

To be sure, the weight of the evidence on the charts still makes a move toward higher rates the greater possibility. However, given the market’s inability to get moving in that direction after months of waffling, there is now a viable argument that it may not happen at all.

Interest rates jumped after the election, thanks to the incoming administration’s tax and spending proposals and the presumed higher inflation that would follow. Yet uncertainty over how many of those initiatives will actually happen kept the trend in check.

That’s not news. What’s more important to chart analysis is the consensus view that, later this year, the bond market will once again be on the lookout for deficits and inflation. That would indeed spark an upside breakout in interest rates on the charts.

This is where it gets tricky. Id we set sentiment aside and only consider what is on the charts today, the view that interest rates will head higher is the most likely to be correct (see Chart 1). As we can see, the current holding pattern, which is classified as a triangle, sits right below the trendline drawn from the early 2011 peak.

Chart 1

30-Yr U.S. Treasury Yield

The longer any market holds near a resisting trendline, the more likely it will be to break out to the upside through that line. That’s because bears can’t take advantage of the waning demand and bulls have time to reenergize.

Of course, that isn’t a guarantee of a breakout, so we have to consider the triangle pattern itself and follow its borders. A move above 3.05%, give or take a few basis points, would break both the triangle and trendline to the upside. A move below 2.98% -- again, give or take a few basis points -- would keep the major declining trend in interest rates alive for a while longer.

Earlier this month, I wrote here that real estate investment trusts (REITs), one of the interest-rate sensitive stock groups, was strong despite the expected rate increase. And at the start of the year, I made the case that income-producing sectors were cheap enough to start buying.

Two weeks ago, high-yielding junk bonds broke out, and the iShares iBoxx $ High Yield Corporate Bond ETFHYG in Your ValueYour ChangeShort position (HYG) moved above resistance to a 19-month high. Clearly, investors are interested in dividend- and interest-producing assets. I think that is one of the reasons why the defensive consumer-staples sector, where many stocks offer beefy dividend yields, is ever so slightly beating the broader market, even as the overall stock-market trend remains strong.

Whether the stock market moves into a corrective decline or not, the bond market and stock sectors that offer bigger dividend yields make a case that interest rates can actually move lower before they move higher. I’ll let economists argue whether that means the new administration can get its policies enacted, or that those policies will have the intended effects even if enacted.

For investors, the triangle patterns in the 30-year and benchmark 10-year Treasury yields are critical.

Whichever way it breaks should set the interest rate tone for weeks, if not months, to come.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.